Janet Yellen, the nominee to be the next leader of the Federal Reserve, was on Capitol Hill last week explaining her outlook on the economy, quantitative easing (QE) and monetary policy.
Quizzed about whether she thought the stock market was in a bubble, Yellen acknowledged that while “stock prices have risen pretty robustly, you would not see stock prices in a territory that suggest … bubble-like conditions.”
Well, not yet.
The Dow Jones Industrial Average marched on to record highs above 16,000 earlier this week, up 22 percent in 2013. In fact, there hasn’t been so much as a healthy 10 percent correction in stocks since October 2011. And the last near-miss decline of -9.9 percent was 18 months ago.
Some investors are growing wary about an overheating stock market.
So it is understandable why some investors are growing wary about an overheating stock market. Not to worry, though, as Yellen assured us: “At this point, I don’t see a risk to financial stability.”
Sounds a bit like famous last words.
In reality, the biggest investment risk may not be an asset bubble bursting, but a continuation of the stock market melt-up.
Probably the single-biggest fear related to the Fed’s extraordinary policy accommodation, know as QE, is that it will inevitably lead to inflation. But the fact is, five years of unprecedented monetary expansion has not yet had much of an impact on the real economy, and certainly not enough to accelerate inflation.
That’s why the chart below from a Fidelity Investments report caught my attention. It graphically displays the expansion in the Fed’s balance sheet (green area), but also shows how the velocity of money (black line) is falling dramatically.
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The Fed’s balance sheet expansion since 2008 has nearly quadrupled the monetary base, but a great deal of this money is sitting as idle bank reserves — not circulating through the real economy. Bank lending isn’t growing at a rapid rate, partly because business and consumer loan demand hasn’t been robust.
In other words, QE hasn’t triggered a big increase in the turnover of dollars moving through the real economy. You can see this in the latest inflation figures too.
The Consumer Price Index is up only 1.7 percent annually, while the Fed’s preferred inflation gauge (personal consumption expenditures) is even more subdued, rising just 1.2 percent. And that measure has been below the Fed’s 2 percent target ever since the first round of QE was rolled out in 2008.
Too little inflation is precisely why the Fed believes a continuation of QE is justified.
The economy down on Main Street may not benefit from QE, but Wall Street is a different story, and there are plenty of signs that QE is inflating financial assets.
* Through mid-November, there were 199 initial public offerings (IPOs) this year that raised $48 billion, up 64.5 percent from the same period a year ago. The last year in which the number of IPOs surpassed 200 was 2007, when stocks peaked.
And it’s not just stocks where the Fed’s money is flowing; bonds are benefiting too.
* Corporate America is finding plenty of cash flowing into bonds, despite rising interest rates. The amount of corporate bonds outstanding rose to a record $6.1 trillion at mid-2013, up a whopping $625 billion over the same time last year.
Companies are using debt-financed share buybacks to help lift stock prices. And it’s not just domestic corporations cashing in.
* Emerging market bond sales are also brisk, rising to $439 billion so far this year through the end of October, and closing in on the 2012 record of $488 billion.
That tells me the Fed’s money is being put to work on Wall Street, instead of Main Street; some markets and sectors are getting frothy as a result.
Still, U.S. stocks may no longer be as dirt cheap as they were in 2009, but that doesn’t mean they are priced in bubble territory either.
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The S&P 500 Index trades at just 15 times projected earnings over the next 12 months (16.5 times trailing EPS), according to Bloomberg data. That’s in line with average stock market valuations over the long term. And I’m still spotting value in some domestic sectors, particularly energy and materials.
However, all but 5 percent of this year’s 25 percent advance in the S&P 500 Index is reflecting not profit growth, which is anemic, but higher valuations.
In other words, an expansion in the market’s price-to-earnings multiple accounts for three-quarters of the rise in stocks this year. That’s as fundamental growth in the economy and corporate profits have played only a supporting role. In fact, stock-price appreciation is outpacing profit growth this year by the widest margin in 14 years.
At least one successful hedge fund manager sees higher valuations as a cause for concern, likely to limit future stock market gains. Ray Dalio of Bridgewater Associates, speaking on CNBC recently, noted that stock market returns are a zero-sum game: As stock prices and valuations rise, the magnitude of expected future returns goes down.
In fact, Dalio predicts stock market gains could average just 4 percent annually over the next decade.
The bottom line: U.S. stocks seem to be fairly valued for the current economic environment; they’re not inexpensive after gains of nearly 200 percent since 2009, but they’re not in bubble territory either.
Although markets look overbought, there’s more upside potential in U.S. stocks, particularly if we enter a melt-up phase. But the best gains over the next year or two are likely to come from outside the S&P 500.
That’s where I’m finding markets that offer investors a compelling combination of attractive valuation and greater appreciation potential, because these markets aren’t as overbought as many U.S. stocks and sectors.
Later today, in a special edition of Money and Markets, I’ll provide details on a few of my favorites and show you how to take advantage of these buying opportunities. And if you have any questions, please visit Money and Markets’ Facebook page and see our “Ask an Editor” feature.
Good investing,
Mike Burnick